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When the U.S. Justice Department charged Standard & Poor’s with fraud this month and demanded $5 billion in restitution, it culminated the Obama administration’s four-year pursuit of financial chicanery masquerading as sacrosanct credit ratings.

Two dozen lawyers were assigned to a probe they called “Alchemy,” for the medieval pseudo-science that tried to turn lead into gold, as the department modeled a federal case on an analogy for failed mortgage-debt packages. They dug into 30 million documents, found cooperating witnesses and say they’ve got the evidence to win in court on an issue President Barack Obama since 2009 has been saying helped bring the U.S. economy to the brink of collapse.

“From the beginning of our effort to deal with the crisis, we had the ratings agencies high on the list,” former Representative Barney Frank of Massachusetts, a Democrat and co- author of the 2010 Dodd-Frank financial regulation law, said in a telephone interview. “Our only frustration is that we couldn’t come up with better ways to deal with them, but we did everything we could think of in the legislation to restrict them.”

A review of legislative and regulatory documents and interviews with current and former administration officials show that frustration with New York-based S&P, the nation’s largest ratings firm, Moody’s Corp. and Fitch Ratings has existed almost since Obama took office.

Failed Talks

What started as an effort by Obama’s Treasury Department to right a system reeling from the worst financial breakdown in eight decades has now become a Justice Department lawsuit seeking $5 billion from S&P’s parent, McGraw-Hill Cos (MHP)., after months of failed settlement talks.

The Justice Department, 16 states and the District of Columbia are suing the firm for fraud. Attorney General Eric Holder called its practices “egregious” and his deputy Tony West, the department’s third-ranked official, said the company played “a significant role in helping to bring our economy to the brink of collapse.”

The fight has so far cut more than $3.9 billion off McGraw- Hill’s market value (MHP), pushed the yields on its $400 million of bonds due November 2037 to the highest level since March 2011 and may threaten the company’s viability.

Company’s Response

“The company does not believe the cases have legal or factual merit and we intend to defend the company vigorously,” Kenneth Vittor, McGraw-Hill’s general counsel, said today in the company’s fourth quarter earnings conference call with investors. Vittor cited the more than 40 other cases the company has fended off in the wake of the financial crisis.

McGraw-Hill fell less than one percent to 44.03 at the close in New York today. The company, which released its fourth quarter earnings, remained above its lows of last week, when the suit drove the company’s shares down more than 25 percent (MHP).

Because S&P is the only ratings company sued by the U.S. so far, some in the financial community say the case is retribution for the 2011 decision by S&P to downgrade U.S. debt.

“Why S&P? They didn’t do anything that Moody’s or Fitch didn’t do,” said Peter Schiff, chief executive officer of the brokerage firm Euro Pacific Capital Inc., based in Westport, Connecticut, in a telephone interview. “The whole thing to me stinks and looks like it’s their way of getting back at S&P.”

Linkage Denied

Holder, the attorney general who has been in the Obama administration since 2009 as officials first started figuring out what to do about the ratings companies, denies any link.

“They did what they did assessing what the creditworthiness was of this nation,” Holder said at a Feb. 5 press conference in Washington announcing the S&P suit. “But they are not in any way connected.”

The administration’s criticism of the quality of S&P and other raters’ products predates the downgrade, starting soon after Obama took office.

“Credit ratings often failed to accurately describe the risk of rated products,” the Treasury Department said in a financial regulation white paper presented by then-Treasury Secretary Timothy F. Geithner to lawmakers.

The white paper, developed in the first months of 2009, Obama’s first year in office, would serve as the basis for the congressional proposals to come. One stated goal was to “reduce the incentives for over-reliance on credit ratings.”

Supervisory Office

The administration proposed the creation of an office to supervise ratings firms at the Securities and Exchange Commission. It would require the companies to disclose preliminary ratings of companies and use different symbols for structured products, to make investors more aware of the risks that may be associated with asset-backed securities and similar financial instruments.

S&P, which had made changes before Obama took office to address its failures in the subprime mortgage crisis, supported parts of what became the Dodd-Frank Act. Aimed at preventing a repeat of the $700 billion bailout of the banking industry, the law created a mechanism to seize and wind down the largest banks and set up the Consumer Financial Protection Bureau and a new regulatory structure for the $639 trillion global swaps market.

Lobbying Campaign

During debate on the measure, S&P resisted a proposal that would allow the government to choose which ratings firm would rate each offering, as well as proposals that would make judges less likely to dismiss lawsuits against ratings firms.

In March 2010, a company lobbyist sent an e-mail to Senate Republican staff members suggesting that lawmakers band together to block the proposal from reaching the Senate floor, according to a copy of the e-mail obtained by Bloomberg News. McGraw-Hill spent more than $3 million lobbying lawmakers in 2009 and 2010, the years of the financial regulation debate in Congress, according to federal disclosures.

While the Financial Crisis Inquiry Commission concluded the ratings firms were “key enablers of the financial meltdown,” Congress and the administration struggled to find consensus on how to reduce the reliance on ratings. Corporations, banks and even governments were required to seek a stamp of approval before bond offerings primarily from just three firms: S&P, Moody’s (MCO) and Fitch, half-owned by Fimalac SA of Paris and half owned by Hearst Corp.

Liability Shield

Michael Barr, the Treasury Department official who led the administration’s efforts to rewrite financial rules, said Dodd- Frank has helped increase transparency in the ratings, gave the Securities and Exchange Commission oversight, removed an existing legal liability shield attached to the companies, and reduced the mandated reliance on their work.

It stopped short of a complete restructuring of the industry dominated by just three firms, pushing against proposals that that would have placed the government in a dominant role in the marketplace, he said.

“You can’t just change it completely overnight,” Barr, a former assistant Treasury secretary and now professor at the University of Michigan, said in a telephone interview.

The SEC has adopted new rules and modified others. It has created an office to oversee and develop rules for the industry.

‘Fell Short’

Still, “fundamental reform of the credit-ratings agencies was an area where Dodd-Frank fell short,” said Aaron Klein, a former Senate and Treasury Department staff member involved in the drafting and implementation of the law. Klein, now director of the Financial Regulatory Reform Initiative at the Bipartisan Policy Center, said he hoped the lawsuit would force lawmakers and regulators to take a fresh look the industry model.

While the SEC was working to carry out the changes, aimed at reducing reliance on credit ratings, political gridlock gripped Washington.

Government debt reached $14 trillion and Republicans were trying to force the administration to cut spending. That’s when S&P reached its Aug. 5, 2011, decision to downgrade the U.S. for the first time in the nation’s history.

The administration disputed S&P’s rationale -- and its math -- when it downgraded the U.S. Treasury credit rating. The administration showed S&P that its 10-year estimate of the U.S. deficit was $2 trillion higher than the nonpartisan Congressional Budget Office. The company revised its figures and still stuck with the reduction from AAA to AA+.

The downgrade proved meaningless in the markets, which still consider the U.S. the safest of bets even as the political gridlock in Washington persists. Yields on 10-year Treasury notes fell to 1.72 percent on Sept. 22, 2011, from 2.56 percent the day of the downgrade. Borrowing costs remain below pre- downgrade levels, at 1.97 percent yesterday.

‘Fundamental Questions’

S&P gave the Treasury a credit rating lower than it had given some of the mortgage-backed securities and collateralized debt obligations that collapsed in 2007 and 2008. The language the administration used to describe S&P’s performance then isn’t much different from how officials describe the lawsuit.

John Bellows, an acting assistant Treasury secretary for economic policy, said in a blog post the company’s decision to downgrade the U.S. even after being shown errors in its analysis raised “fundamental questions about the credibility and integrity of S&P’s ratings actions.”

The company, as it stood by its decision, said the reaction from Treasury and the White House was typical of a country that had just seen their sovereign credit cut.

Potential Penalty

The Justice Department says the suit isn’t related to the downgrade or any political decision. It says it took time to build its case that the S&P made false representations, concealed facts and manipulated ratings criteria linked to the financial instruments that helped trigger the financial crisis.

Still, the announcement of the suit puts a level of pressure on S&P that isn’t on other raters -- at least not yet. The $5 billion potential penalty would equal more than five years profit (MHP) for McGraw-Hill. The company faced battered shares and Fitch put its ratings on watch for possible downgrades.

Sheila Bair, the former chairman of the Federal Deposit Insurance Corp., said she questioned “why it’s just S&P.”

“If they think there was fraud and defrauding of financial institutions, which is the basis of this suit, you would think others would be brought in as well,” Bair said today in a Bloomberg Radio interview.

The White House has declined to answer questions on the lawsuit, directing reporters to the Justice Department.

Documents, Witnesses

To prepare its suit, lawyers from the Justice Department’s civil division and the U.S. attorney’s office in Los Angeles sifted through more than 30 million pages of documents, including e-mails, according to a department official briefed on the case. Interviews were conducted with more than 100 individuals, including meetings with cooperating witnesses, said the official who requested anonymity to discuss the case.

“Our lawyers and staff served hundreds of civil subpoenas, spent thousands of hours reviewing and analyzing millions of pages of documents, and contacted and interviewed over 150 witnesses, including dozens of former S&P analysts and executives,” Stuart Delery, head of the Justice Department’s civil division, said last week flanked by 7 of the 17 state and District of Columbia attorneys general who have also brought suits against the company.

Government and S&P lawyers had multiple, extensive exchanges in the months before the filing of the lawsuit, the official said. They were unable to come to an agreement.

Unproductive Talks

Two other people briefed on the case described settlement discussions, which started late last year, as unproductive in the weeks leading up to the lawsuit. By the time the case was filed, the two sides remained far apart on any agreement, said the people, who requested anonymity to discuss private talks.

Both sides say they are ready for the case, filed in California, to go to court. S&P hired San Francisco trial attorney John Keker, who has represented investment banker Frank Quattrone and Enron Corp (ENRNQ). executive Andrew Fastow, to join its defense team. Quattrone, founder of Qatalyst Partners, won dismissal of all criminal charges that he obstructed a federal investigation into Credit Suisse AG. Fastow pleaded guilty in 2004 to two counts of wire and securities fraud.

Spokeswoman Catherine Mathis said the firm would “vigorously defend S&P against these unwarranted claims” which she said were part of “meritless civil lawsuits.”

“Claims that we deliberately kept ratings high when we knew they should be lower are simply not true,” Mathis said in a Feb. 5 statement.

‘Win’ Expected

Holder said the Justice Department “would not have brought this case unless we felt we had a case that we could bring and that we would win.”

“And that’s what I expect to have happen,” he said.

Holder and West declined to comment on whether Moody’s or Fitch might face similar charges.

Penalties for false representations, concealed facts and manipulated criteria linked to ratings on portions of more than $4 trillion of debt securities could reach $5 billion, the Justice Department said. That is more than enough to exhaust New York-based McGraw-Hill’s $1.2 billion of cash on hand and the $1.86 billion of excess funds that analysts project the company will generate this year.

Floyd Abrams has defended S&P’s ratings on free speech grounds. Abrams is the Cahill Gordon & Reindel LLP attorney who defended the New York Times and won a Supreme Court decision upholding the publication’s First Amendment rights in the Pentagon Papers case, and then faced criticism for his work defending reporters in the investigation over the leak of a Central Intelligence Agency operative’s name during President George W. Bush’s administration.

New Approach

The lawsuit’s approach, alleging that S&P knew its ratings were faulty, will require a different defense, Abrams said in a Feb. 5 Bloomberg Television interview.

“It’s not a First Amendment case,” Abrams said in the interview with Sara Eisen. “The government is alleging that S&P didn’t believe what it said; the First Amendment doesn’t protect against that.”

Abrams, who will be joined by Keker in defending the company, said S&P’s lawyers held settlement discussions with the Justice Department for at least four months. Vittor, the McGraw- Hill lawyer, said the company is open to “a reasonable settlement opportunity” in any case.

“The complete record does not support the government’s theory,” Vittor said the conference call with investors. “Although there may have been opinions within the company, even very strongly held opinions, that did not carry the day, this is not evidence of fraud.”

Former SEC Chairman Arthur Levitt predicted in a Feb. 6 interview on Bloomberg Television there would be “a substantial settlement” between the company and the government.

“The government is trying to win, and McGraw-Hill is foolish not to have made a settlement with them,” said Levitt, who is on the board of Bloomberg LP, the parent company of Bloomberg News.

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